Assessing counterparty risk and compliance in crypto staking: Relevant questions to guide your due diligence.
As proof-of-stake networks grow across the crypto industry, staking crypto assets has become an increasingly attractive financial tool for individual and corporate investors. The value of assets locked in liquid staking services jumped 292% to $20 billion as of September 2023, according to DefiLlama. This growth has not gone unnoticed by institutions seeking to explore the crypto space, with 74% of companies committed to exploring digital assets and over 63% optimistic about the broader cryptocurrency space.
However, a lack of compliance and due diligence remains a major barrier for potential investors. Results of a recent survey of UK cryptocurrency firms found that only one in five (17%) companies consistently verify new customers, with half admitting to only performing these checks occasionally.
Therefore, as digital assets and staking services become more popular, it becomes more important for investors to assess counterparty risk to thoroughly protect their portfolios. For EU or offshore institutional investors from any other jurisdiction, it is crucial to ask the right questions to staking providers. Therefore, the following five key questions will help determine the authenticity of your staking provider.
Will your collateral provider expose you to U.S. law or the SEC?
One of the key aspects to consider when choosing a collateral provider is the legal jurisdiction in which it operates. Specifically, users should ask the collateral provider whether it places itself under the jurisdiction of U.S. legal jurisdiction and/or regulatory agencies such as the Securities and Exchange Commission (SEC). It is worth noting that collateral providers operating under U.S. legal jurisdiction may pose counterparty risks to investors.
In contrast, the EU has a clear regulatory framework for crypto assets, providing investor protection and setting requirements for crypto asset service providers (CASPs). Some countries also impose capital controls or bans on cryptocurrency businesses, which may affect the ability of international investors to use certain staking services.
Local laws also affect the onboarding process and anti-money laundering regulations, which in turn affects investor access and compliance risks. Finally, the jurisdiction also affects the legal ownership of the pledged crypto assets and what happens in the event of bankruptcy or government seizure. From the above factors, better jurisdiction laws affect many factors, such as asset security, market liquidity, and investor tax requirements.
At the same time, as regulations continue to develop, investors need to be aware of the potential consequences of doing business in unclear jurisdictions such as the United States and, depending on their own course of action, choose to avoid these countries altogether or continue to do business under the yet-to-be-completed legislation to ensure that they do not incur the wrath of local regulators. Investors may also benefit from following the lead of other players operating in the aforementioned jurisdictions, who have acquired greater industry common sense in ensuring compliance in the face of uncertainty.
Does your staking provider have audited financials and undergo regular third-party audits or assurances about its operations?
Transparency and compliance are also important factors when choosing a staking provider. In order to gain confidence in its operations, it is important to determine whether the staking provider has its financials audited and regularly undergoes third-party audits or assurances on its operational practices. Staking providers incorporated in the EU or the US typically follow accounting standards such as US Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), which require audited financial statements.
Additionally, collateral providers can register as crypto-asset service providers under the Markets in Crypto-Assets (MiCA) regulations, providing further documentation of their anti-money laundering (AML) and compliance systems. This registration ensures that they have internal controls, policies and procedures to identify, assess and manage risks, including money laundering and terrorist financing risks, as well as business continuity plans.
How does your staking provider ensure that funds do not (accidentally or otherwise) contribute to the generation of staking rewards that could benefit sanctioned entities?
Investors should also be cautious of any risk of sanctioned entities or jurisdictions. Investors require collateral providers to clearly state the potential use of funds in order to inadvertently facilitate rewards that could benefit sanctioned entities.
Direct exposure to sanctioned entities may result in investors being legally obliged to report such exposure to relevant authorities, such as the Office of Foreign Assets Control (OFAC) or the Financial Crimes Enforcement Network (FinCEN) in the United States, the European Banking Authority (EBA) in the European Union or the Office of Financial Sanctions Implementation (OFSI) in the United Kingdom. It is therefore important to ensure that collateral providers have strategies and processes in place to meet these obligations and mitigate potential risks.
How does your collateral provider ensure that funds are not commingled and funds are segregated?
Another important aspect to consider is how to enforce the separation and isolation of funds. Institutional investors often require custodians to ensure that funds are isolated and held in compliance with regulatory requirements, such as the EU's Markets in Crypto-Assets (MiCA) regulation. However, in some cases, when a pledge is initiated, funds need to leave the custodian and be submitted to the chain through a transaction.
This process may result in the commingling of funds using smart contracts or protocols, which must be carefully monitored and assessed by the collateral provider or custodian. Understanding how collateral providers ensure the separation and segregation of funds is critical to minimizing the risks associated with commingling to ensure compliance with regulatory standards.
Which counterparties does your collateral provider give you access to?
The counterparties involved in staking may vary from provider to provider. A detailed understanding of counterparty risk exposures, such as smart contracts or decentralized autonomous organizations (DAOs), is critical to assessing the associated risks. Decentralized staking providers organized as DAOs or utilizing smart contracts require a thorough risk assessment, including financial stability, operational security, code and governance review, and regulatory compliance.
Centralized staking providers, on the other hand, must comply with current and future cryptocurrency regulations, as well as anti-money laundering/counter-terrorist financing (AML/CTF) laws and securities laws.
It is therefore important to confirm that the collateral provider conducts thorough checks on the source of funds and ultimate beneficial owner (UBO) proof of its clients. This ensures compliance with AML requirements and helps prevent investments from benefiting from illicit funds. Compared to other service providers in alternative investments, strict AML practices, policies and systems should be the minimum requirement for collateral providers.
The development of standards
While staked crypto assets represent an attractive financial opportunity, it is imperative that investors conduct thorough due diligence on staking providers and continue to make the right demands of them. With so many factors at play, asking probing questions such as the ones above will help potential investors fully understand how their funds will be handled and what protections are in place.
Staking lays a solid foundation for the continued institutional adoption of digital assets. While being attracted by the prospect of high yields and generating additional value, investors need to fully understand the risks associated with staking practices. This burden should increasingly fall on the shoulders of staking providers, who need to ensure that they provide potential investors with clarity, direction and strategies to capitalize on the industry and its growth, thereby driving its adoption in the coming years. #加密货币 #质押
